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Netflix: Down, but not out

November 23, 2011: 5:00 AM ET

If you're into buying stocks on the turn, now may be the time for Netflix.

Netflix

Out with the old.

FORTUNE -- If you're looking for a stock to kick around and are getting bored of banks, look no further. I present to you Netflix, the undisputed whipping boy of late 2011.

It all started with the controversial price hike in the summer and continues to this very day. Earlier this week, Netflix dropped a "double bomb" on the market. First, the company announced a highly dilutive offering of equity and convertible notes. And second, it extended loss forecasts throughout the entirety of 2012. Next year, in other words, ain't looking much better than this one. The stock dropped 5.4% yesterday, to $70.45.

While the bears are obviously winning the debate at the moment, there's a bullish side to every data point they've latched onto of late.

First things first: the company's public relations fumble this summer. When Netflix (NFLX) announced that the cost for customers who wanted both streaming and DVD rentals would rise from $10 to $16 a month, an outraged clientele rushed for the doors. Never mind that it was a paltry $6 a month increase and that the previous $10 for free streaming content and DVDs was a real bargain. Americans have a predilection to get a hate on for just about anybody with the audacity to raise prices these days—see Bank of America and its $5 debit-card fee—and the turnabout in the company's fortunes was really about as dramatic as they come: the company had to slash third-quarter subscriber estimates by 1 million, or 4%, to 24 million. Reed Hastings, whom Fortune had named Businessperson of the Year in 2010, suddenly looked ham-handed, and found himself apologizing not once (for the price hike) but twice (for its short-lived plan to separate the two businesses, into Netflix and Qwikster.)

As kids cut the cord, Dish Network looks online

Investors naturally (and appropriately) punished the stock for the fallout from the company's miscues. At $70.45, it sits at just 23% of its 52-week high of $304.79. Have the company's prospects really fallen by 77%? Not even close. What happened, though, was that the halo this stock has worn for quite some time disappeared. Anybody who previously said the stock was really worth $305 with a straight face was either trying to sell you some shares or wanted Wall Street business from the company. But now that everybody is down on it, it may be time to back up the truck. Or at least the wheelbarrow.

Is today's price closer to reality? It surely is. But just as deteriorating sentiment can punish a stock, improving sentiment can help it move back up. It's hard to see the Netflix brand do anything but improve over the next year, especially as it beefs up the user interface while also adding content. If you're into buying stocks on the turn, this is the time for Netflix, at least as far as consumer sentiment goes.

Rising costs

Next up: those billions in content acquisition costs. Some of the big numbers people are tossing around lately are the rapidly rising costs of new content for Netflix. Whereas the company once had Hollywood running scared and cutting deals favorable to Netflix just to get in the streaming game, the tables have half-turned, and content producers like Dreamworks (DWA) and CBS (CBS) are extracting a pretty penny in exchange for rights to their television shows and movies. Netflix has already committed to more than $3.4 billion of payments for streaming content over the next five years. That includes smallish deals such as an estimated $35 million for the exclusive rights to AMC's cult hit The Walking Dead in the U.S. and much larger ones such as an estimated $1 billion for 700 hours of CW shows, including Gossip Girl and The Vampire Diaries, as well as future seasons through 2015.

These are big numbers, sure. But as the inexorable shift away from DVD and toward streaming content continues on its merry way, they are also Netflix's primary cost, as well as a competitive bulwark against incursions from the likes of Amazon Prime and Hulu Plus, which will not be able to offer their customers the same lineup. The company is expected to bring in $3.6 billion in subscription revenues in 2012 and $4.2 billion in 2013. Those are big numbers too. Gross margins, which have been under pressure this year due to subscriber defections, are going to recover, especially as the company's DVD fulfillment costs continue to drop. A bearish trend today will be a bullish trend tomorrow. You can bet Netflix isn't going to announce any new major content deals until there's more clarity on subscriber growth, so there's nothing but upside here for now, at least for the time being.

Expansion, not contraction

Third factor: This week's announcement of a $400 million capital raise. Yes, it's bearish on its face, given the estimated 10% dilution of common shareholders. And yes, it's always more encouraging when a company can generate enough cash flow that it need not tap the capital markets to fund its growth.

That said, Netflix is building a business. It's expanding overseas—in Brazil and the UK, most notably—and quite reasonably decided to pad its pockets with some extra lucre in order to ensure it will be able to pay its bills. And consider the fact that venture capital firm Technology Crossover Ventures, which put up $200 million of the total for convertible notes with a strike price of $85.80, recently hired ex-Netflix CEO Barry McCarthy. Insiders of a company will always tell you the stock is a buy. But I can't think of a better sign than an ex-insider using outsider money to buy shares. If the guy is wrong on this one, he might be out of a job. And I can guarantee you that he knows more than the rest of us do about the company's short- and long-term strategies. T. Rowe Price (TROW) also kicked in $200 million, but its deal allowed them to purchase Netflix shares at $70 apiece, so it's hard to see that as much more than doubling down at a discount price. Still, the TCV endorsement is a solid one.

While Netflix has been taking a beating of late for its ill-timed share buybacks and share issuance (read: it bought very high and sold very low), I'm willing to give them a mulligan on this one. While the company might have handled its subscription price increase with more finesse, Netflix remains a company that is channeling the spirit of Steve Jobs—charting the future (i.e., to streaming) and trying to leave the past (i.e., DVD-by-mail) behind. Its mistake was not realizing that people who already pay hundreds of dollars a month for their cellular, cable, and Internet service would go into outright revolt over a marginal $6 increase in their monthly bill.

Netflix and Amazon aren't as bad off as it seems

Of course, when it all comes down to it, Netflix is a subscription business, pure and simple, and you've got to keep your subscribers happy. The reason the stock has cratered this year is because a company once used to growth-upon-growth and an evangelical customer base suddenly couldn't hold onto its erstwhile fans. It's still enduring higher-than-usual churn, but those for whom a $6-a-month price hike was an intolerable affront have already left. And there's a bigger wave flowing in the other direction—that of consumers who have yet to even experience the joys of streaming video-on-demand. The company has just under 24 million subscribers at the moment. Barclays Capital analyst Anthony DiClemente sees them coming close to 29 million by the end of next year. Don't be surprised if they make—or even exceed—his forecast. Especially when people hear that Hastings had the supreme wisdom to cut a deal to bring Arrested Development back from the dead. The man's a genius on that basis alone.

All of the above factors have been working against Netflix of late. Costs are up, subscribers are down, equity is diluted, and the bloom is off Reed Hastings' rose. But all four could turn in the other direction at some point next year. At which point you'll be wishing you'd bought the shares at $70.45.

Oh, and one more thing: as with its loss-leader war against Apple (AAPL) with the Kindle Fire, Amazon (AMZN) has shown signs that it intends to be a major player in streaming content. It can do that in one of two ways. One: spend the billions that Netflix has already spent on content to try to duplicate its offerings, and hope it can lure subscribers away from the industry leader. Two: spend those same billions to just buy Netflix outright. If you were Jeff Bezos, which would you do?

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About This Author
Duff McDonald
Duff McDonald
Contributing Editor, Fortune

Duff McDonald is a contributing editor at Fortune. He has also written for New York, Vanity Fair, Condé Nast Portfolio, GQ, WIRED, Time, Newsweek, and others. In 2004, he was the recipient of two Canadian National Magazine Awards -- best business story (gold) and best investigative reporting (silver) -- for "Conrad's Fall" in National Post Business. Last Man Standing, his biography of Jamie Dimon, chairman and CEO of JPMorgan Chase, was published by Simon & Schuster in October 2009. He is also the co-author, with Owen Burke, of The CEO, a satire.

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